As more registered investment adviser (RIA) industry momentum builds in support of SEC investment adviser user exam fees, we wanted to share some analysis on the potential financial impact to RIA firms. To provide some background, Representative Maxine Waters first introduced the "user fee bill" in Congress in 2012. Until recently, it's garnered little bipartisan support, however it's recently received a bit more support in Congress. However, even if the bill is to pass one day, it's likely still at least a few year away. For reference, the proposed bill's official title is the Investment Adviser Examination Improvement Act of 2013.
Users fees have generated quite a bit of industry support as of late as an attractive alternative to both FINRA being the self-regulatory organization (SRO) for RIAs and examinations being conducted by third parties. While there is still some debate as to whether annual user fees are a more desirable alternative to third-party audits, the industry as a whole seems to be united in that it does not see FINRA as a preferred option. Yet, there hasn't been much recent financial analysis done to explore the costs of the various alternatives.
According to the Investment Adviser Association (IAA), a 2011 economic analysis by the Boston Consulting Group estimated that increasing the number of investment adviser examinations to average each RIA firm being audited once every four years, would lead to an annual increased cost of $100-110 million. In comparison, the annual increased cost for an SRO operated by FINRA would be $550-610 million. Given there's been some more recent clarity on the details of potential user fees to fund increased investment adviser examinations, we thought we'd do some number crunching ourselves. In short, we estimate that the annual increased cost to RIA firms for user fee-funded examinations would be around $310 million. However, the good news is that the vast majority of the over 32,000 RIA firms registered at the state and SEC levels would be faced with little or no expense. Below is a break-down of our detailed analysis along with some interesting observations and a deeper look into the proposed bill itself.
First let's take a look at the bill introduced in Congress
As the bill stands today, here are some key highlights that RIA firms should understand:
- Section 3(e)(2) makes it clear that any state-registered investment advisory firm would be exempt from paying any user fees to the SEC. Thus, according to SEC estimates, this bill would only impact around 11,500 SEC-registered RIA firms which means the vast majority of the overall estimated 32,000 investment advisory firms would not be impacted at all. While there a number of exceptions, in general investment advisory firms with $100 million or more in assets under management (AUM) register with the SEC and firms with less than $100 million in AUM register with the relevant state(s).
- Section 3(e)(3)(A)(ii) states that the total user fee would only be charged to cover the incremental number of examinations conducted compared to the number of exams which were conducted by the SEC in 2012. Given this bill version was authored in 2013, let's instead assume that an updated bill would utilize the examination figures for 2013. According to the SEC's 2015 fiscal year budget request, the SEC examined 964 investment advisory firms during the 2013 fiscal year which equates to around 9% of SEC-registered firms.
- Section 3(e)(3)(B)(i-iv) provides some basic criteria on how the per firm user fee would be calculated:
Next let's gather some facts and make some assumptions
A careful review of the SEC's historical budget proposals and data from Meridian-IQ on the number and size of investment advisory firms and the current examination effort helps us start with these facts:
- Total number of SEC-registered RIA firms: 11,500
- Total AUM of SEC-registered RIA firms: $55 trillion
- Number of SEC investment adviser examinations conducted in 2013: 964
- Total combined AUM for 100 largest SEC-registered RIA firms: ~$31.1 trillion
- Actual SEC Office of Compliance Inspections & Examinations (OCIE) salaries and benefits costs for 2013: $184.291 million
- Proposed SEC OCIE salaries and benefits costs for 2015 budget: $261.700 million
- Total number of proposed new OCIE hires in 2015 budget: 316
- Number of proposed new OCIE hires in 2015 budget which would be RIA examiners: 240
- Number of proposed SEC investment adviser examinations to be conducted in 2015: 1,325
- Number of current OCIE RIA examiners: ~450
We next make the following assumptions which are likely to not be fully accurate, but should be within reasonable range of actual figures:
- Percentage of total increase of OCIE salaries and benefits costs which can be attributed to RIA examiners: 50%. This is a rough estimate given that around 240 of the 316 (75.9%) new budgeted OCIE hires would be RIA examiners. There's also travel, management overhead, and other costs to consider. We then discount this amount to take in account raises for existing employees and the assumption that future new hires may be a bit more efficient in the number of exams performed as it's likely that the SEC would be auditing smaller firms at a higher frequency than it may presently. As discussed a bit further below, we assume that audits for smaller firms are generally a bit less time-intensive and thus less costly for staff members to conduct.
- Targeted frequency of examinations: Every 3 years. This would be lower than the current broker-dealer rate of approximately every 2 years but would be in-line with many states.
And finally, let's crunch some numbers
If we assume 50% of the total increase in OCIE salaries and benefits costs can be attributed to the cost of new investment adviser examiners, the total incremental examination cost is estimated to be $38.7 million. This would lead to total increase of 361 examinations (1,325-964). This leads to an estimated per examination cost of around $107k. At first glance, that figure appears a bit high but it may not be far off given it appears that the current number of ~450 examiners conducted 964 exams in 2013 which equates to about 2.14 exams per examiner. This is clearly a statistic the SEC is focused on improving in terms of efficiency and is likely driven by examinations of some of the largest RIA firms. In other words, this is a case in which the average cost to conduct an investment adviser examination is likely significantly higher than the median cost as the average is driven up by some very large and complex advisory firms.
To calculate the annual number of incremental examinations compared to the 2013 figure of 964 exams, we first estimate how many total examinations need to be performed on an annual basis assuming a 3 year cycle. With 11,500 firms, that equates to 3,833 audits per year. We next remove 964 from that figure to account for the current number of exams and are left with an annual incremental total of around 2,897 exams.
Taking the $107k cost per exam across 2,897 total exams every year, the incremental annual cost is estimated to be $310.654 million. Given 11,500 total firms, the average annual cost per SEC-registered RIA firm is $27,013.
Ok, but what does this mean for my actual firm?
If we assume that the main criteria for calculating a firm's annual user fee is AUM, then we can begin to estimate the projected annual cost of a firm's annual user fees. In actual practice, it appears that AUM would be the main, but clearly not the single driver of annual user fees.
With a total incremental annual cost of $310.654 million and $55 trillion of total AUM across 11,500 firms, the annual cost per $1 million of AUM comes out to $5.65.
Looking across the x-axis, the figures are in millions of AUM. For example, $500 represents $500 million in AUM whereas $2,500 represents $2.5 billion.
Assuming all 11,500 SEC-registered RIA firms pay the annual user-fee based solely on AUM, then the vast majority of traditional RIA firms ranging from $100 million to a few billion in AUM will not face too substantial of increased annual fees. Assuming an investment advisory firm with $250 million in AUM charges 1% and earns $2.5 million in annual revenue, the projected $1,412 annual fee translates to 0.056% of revenue. Furthermore, a firm with $2.5 billion in AUM is estimated to pay an annual user fee $14,121 which is still only about 50% of the average user fee paid by all firms registered with the SEC. This is because the average cost per firm is being driven up tremendously by the largest firms.
To further illustrate this point, the top 100 largest RIA firms, a group which includes wirehouses, banks, and asset managers, absorb around 56.5% of the total annual user fees given that the top 100 firms have over $31 trillion in combined assets under management of the total $55 trillion of AUM across all 11,500 SEC-registered investment advisers. In such a scenario, the top 100 firms as a group are paying $175.423 million per year.
The firm that may be hit the hardest is the Vanguard Group which is, according to Meridian-IQ, presently the largest RIA firm and has about $2.35 trillion in AUM and single-handedly comprises around 4.3% of the entire RIA industry in terms of AUM. It alone would be facing an annual user fee of approximately $13.268 million. As a percentage of Vanguard's AUM, that's obviously a very small figure, but given the fact that Vanguard's blended advisory fee as a percentage of AUM is significantly lower than traditional RIAs, perhaps in the range of 10 bps (0.1%) or so, the annual user fee could move to closer to around 0.5% of annual revenue for Vanguard. Two other industry titans that could be phoning their lobbyists shortly include PIMCO ($11.017 million) and Capital Research & Management Company ($7.257 million)
Ok, but what could go differently and create problems?
- Wirehouses, banks, and large asset managers succeed in influencing the legislation: It's likely that some of the largest RIA firms will lobby hard to be excluded from or to not be on the hook to absorb such a significant percentage of the annual user fees. It's entirely unclear if the largest firms will have any success in influencing this legislation, but it's something to watch very carefully. In such a scenario, the annual user fees charged to smaller RIA firms registered with the SEC would more than double.
- Dually-registered RIA firms are excluded: It's possible such firms that are also registered as broker-dealers, which also happen to be many of the largest RIA firms, may argue that they are already paying annual fees to FINRA and thus should not be required to pay or be allowed to pay reduced investment adviser examination user fees. Again, in this scenario, annual user fees charges to smaller SEC-registered firms could more than double.
- The SEC sets a minimum annual firm fee regardless of AUM: This is perhaps the greatest threat to small SEC-registered RIA firms. A minimum annual fee of $20,000 per firm would equate to 2% of revenue for a typical $100 million firm and would definitely be felt. This could also be particularly troublesome for mid-sized investments advisers with between $25-$100 million in AUM in the state of New York that are required to be registered with the SEC. To further quantify this, Meridian-IQ estimates that there are approximately 4,962 firms registered with the SEC with $1 billion or less in AUM which as a group combine to manage $1.288 trillion in assets. Under the current user fee assumptions with no minimum annual per firm charges, this group as a whole would be paying ~$7.237 million in annual user fees which equates to 2.3% of the total projected annual cost of $310.654 million. If instead a $20k minimum annual charge per firm was applied, this group would now be paying ~$99.240 million in annual user fees which comes out to 31.9% of the total cost. In other words, SEC-registered RIA firms with $1 billion or less in AUM would be paying close to 14x more per year.
- The massive increase in examination staff proves difficult and costly: The SEC will be asked to move from auditing RIA firms on average once every 11 years as it does now to once every 3 years. That is nearly a 4x expansion in annual examination capabilities. Any organization would struggle with such rapid hiring growth. It's possible that training may take longer than anticipated, proper talent may require more compensation, turnover may increase, and so forth. In other words, it may be more costly than initially projected regardless of the implementation details.
- An expansion of the SEC's enforcement staff also needs to be funded: What's a bit unknown right now is whether a likely needed increase in SEC enforcement staffing may also be factored into the annual fee. In 2013, around 9% of SEC investment adviser examinations resulted in a referral to the Division of Enforcement. While it's unlikely to be a perfect correlation, a close to 4x increase in the number of annual RIA audits should also lead to a significant increase in the number of firms referred to the Division of Enforcement.
- The SEC chooses to get on a 2 year audit cycle: This would be more in-line with broker-dealers so it's something that will likely be considered. This would increase the average annual user fee by 67% compared to our present analysis. The targeted annual audited cycle is a key driver of the ultimate annual expense as illustrated here:
Looking across the x-axis, we explore the cost of exams conducted between once every year to conducted once every five years.
As the above chart illustrates, the frequency of exams is a major driver of overall user fee costs. If the SEC shifted to a 2-year cycle compared to our originally modeled 3-year cycle, the total annual estimated cost to all SEC-registered RIA firms would increase to $516.149 million. Alternatively, if investment advisory firms were placed on a 4-year cycle, the total annual estimated cost would decrease to $207.906 million.
It will be interesting to watch how this political debate evolves. While the present analysis shows that the annual cost to small investment advisory firms registered with the SEC should be fairly manageable, there are a number of significant risk factors which could dramatically increase the overall annual cost and shift more of the cost burden to smaller firms.
Be sure to check back soon for a similar cost analysis on instead creating a program for third-party investment adviser compliance exams. We also plan to explore some other alternatives that have to yet receive much industry attention.